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This study examines how China's monetary policy affects local government borrowing costs and subsequently impacts the broader economy through what the authors call the "local government bond channel." Using both empirical evidence and a DSGE model with multi-level government structure, the researchers find that when local governments can borrow at risk-free rates, monetary policy stimulus produces output responses more than twice as large as baseline models. The analysis reveals significant regional variations in how local governments respond to monetary policy changes, with cross-regional financial spillovers and inter-governmental competition both moderating the transmission effects.
Why it matters
Understanding this transmission mechanism is crucial for Chinese policymakers designing effective monetary interventions, as it demonstrates that local government borrowing conditions substantially amplify or dampen national monetary policy effects. The findings suggest that regional heterogeneity must be considered when forecasting the economic impact of monetary policy changes in China's transitioning economy.
Understand the Science
by Jinzhi Bai, Hanlin Xia, Lin Zhang
China’s economic development and change are significantly influenced by local governments. By affecting the cost of borrowing for local governments, monetary policy can have an impact on their fiscal policies and, eventually, the actual economy. After providing empirical evidence to support the existence of the local government bond channel of monetary policy in China, this paper builds a DSGE model with a multi-region and multi-level government structure in order to quantitatively analyze the impact of the local government bond channel of monetary policy. The findings indicate that local government borrowing costs have a major impact on the transmission of monetary policy. The stimulus impact of monetary policy is significantly increased when local governments may borrow at the risk-free rate, resulting in an output response that is more than twice as large as that of the baseline model. With some cross-regional financial spillovers among local governments, the output response at the average response is lower than in the benchmark model, but the output response at the 75th percentile bond rate is more than twice as large. Since local government borrowing costs respond differently to monetary policy, there are notable geographical consequences of monetary policy. Competition among local governments reduces the impact of monetary policy transmission. This paper’s quantitative analysis offers a fresh analytical viewpoint on how China’s monetary policy is transmitted during periods of transition.
Source: The local government bond channel of China's monetary policy